When tax cuts lead to higher tax rates

Tax cuts are universally popular – at least with those who benefit from them. Unfortunately, modern day tax codes are so complicated that what is intended to be a broad-based tax cut can lead to an increase in the effective tax rate for most recipients. Don’t believe me? Then let’s take a look at the so-called ‘Trump tax cuts’ of 2017.

These tax cuts, officially called the Tax Cuts and Jobs Act of 2017 (TCJA) were a major achievement of the Trump Presidency. The key provision of the TCJA was the introduction of a flat tax on corporate profits at 21%. Until then, businesses had to pay a tax of 15% for the first $50,000 in profits, then 25% for the next $25,000, 34% for the next $25,000 and so on. As you can see from the chart below, practically all tax rates were reduced significantly. What’s not to like about this kind of tax cut?

US corporate income tax rates before and after the TCJA

Source: Liberum

Indeed, after the introduction of the TCJA, the effective tax rate of publicly listed companies dropped sharply from about 17-18% to about 11%. Meanwhile the effective tax rate for privately owned domestic companies increased from about 12% to 13%. Doesn’t sound that bad at first, but the vast majority of companies in the US are in this category which is why the overall effective tax rate paid by companies in the US increased because of the tax cuts.

Effective tax rate changes from the TCJA

Source: Dobridge et al. (2023). Note: MNE = Multinational enterprise

Two provisions of the TCJA were responsible for this weird result.

First, the introduction of the flat tax of 21% meant that small companies with few profits had to pay more taxes (21% instead of 15%). This hits small family-owned businesses particularly hard because they often have barely any profits to begin with.

Second, the loss provisions for the carryover of losses changed. Before the adoption of the TCJA companies could use losses in the current tax year to either claw back taxes paid on profits in the previous two tax years or carry these losses forward to offset future profits. Under the TCJA, losses in the current tax year could no longer be used to claw back taxes paid on past profits and could only be carried forward to offset up to 80% of future profits.

In the end, companies that are barely profitable and often have years when they make a loss were the big losers of the tax reform. Large corporations did just fine while small business owners got to pick up the bill.